Developers are lobbying to allow buyers of new homes to deduct mortgage interest from their taxable income, according to The Globe’s reporting.Cole Burston/The Globe and Mail
When it comes to housing policy, Canadian politicians twist themselves into knots trying to explain how they will make homes more affordable while not reducing the value of homes. The impossibility of this conundrum makes them susceptible to a danger identified by the satirist H.L. Mencken: for every complex problem there is an answer that is clear, simple – and wrong.
One such solution has recently been floated around Ottawa. According to reporting by The Globe and Mail, developers are lobbying to allow buyers of new homes to deduct mortgage interest from their taxable income.
Such a move, they claim, would make homes more affordable for first-time buyers. And it would be balanced by those people who choose to deduct their mortgage interest having a corresponding decrease in the capital-gains exemption when they sell the home. Canadians generally do not pay tax on appreciation of the value of their primary residence.
This weekend The Globe proposed a number of ways to improve tax policy, aiming to boost productivity, improve fairness across generations and encourage rental construction. The mortgage interest idea is – for good reason – not one of them. In fact, it lives up to Mencken’s maxim. It’s a clear and simple solution to a complex problem. It’s also wrong.
There are a number of problems with it.
For one, economic theory and common sense tell us that this will instead raise prices, by inflating demand. That is because the net effect of allowing people to deduct their interest payments is that they will be able to take on a bigger mortgage for the same out-of-pocket cost. With extra buying power, they will be able to bid more and thus push up prices.
Cruelly, this market inflation will hit all buyers, not just the ones who deduct their interest. Which will have two effects. It will encourage more buyers to deduct their interest, throwing fuel on the problem in a spiral of price inflation. And it will make newly built homes, which allow the deduction, more attractive than existing homes, and thereby supercharge suburban sprawl.
Such a deduction would also create a perverse economic incentive. Consider how someone who has saved up a hefty nest egg for a down payment might proceed after such a policy change. They could make as large a down payment as possible in order to minimize their mortgage. But under the new policy another option presents itself.
That person suddenly faces the possibility of ending up ahead by minimizing their down payment. This results in a larger mortgage, yes, but the interest payments on it are deducted from taxable income. So they may be able to save quite a bit off their tax bill with the larger mortgage. It’s effectively an income boost. That might be good for them, but not for Ottawa’s coffers.
As well, the idea raises questions such as what happens if future price gains aren’t enough to offset the interest deduction. And it ignores the fundamental truth that a dollar today is worth more than a dollar decades from now.
Also lurking in the future is a political problem. In this case, the buyers who choose to forgo mortgage interest deduction are passing a version of the marshmallow test of deferred gratification. They are resisting an immediate benefit and waiting for a future one: full capital-gains exemption on their home.
However, the looming political problem is that people who took the immediate benefit by deducting their mortgage interest may find themselves with buyer’s remorse. After all, for a lot of Canadians their retirement plans rely on cashing out on real estate. In an era in which few people have good pensions, the home has become a financial lifeline. That is why politicians are so loath to do anything that hurts equity.
So it’s easy to imagine the people who took the deduction trying to have their cake and eat it too. In a fair world they wouldn’t. In a judicious world they would invest their short-term benefits and end up equal, if not ahead. But in the real world, nothing would stop them enjoying the immediate benefit and then clamouring in decades to come for special tax treatment. And if there are enough people in this group they could prove a potent political force, difficult to ignore.
Canadian governments have struggled to manage housing affordability, too often juicing demand instead of focusing on supply. Allowing mortgage interest deduction would be more of the same. As Mencken warned, there are no simple solutions. At least not ones that work.